Conversation with Professor Baruch Lev at NYU: Is Accounting Outmoded?

The book: The End of Accounting.

July 17, 2017

by Hank Boerner – Chairman and Chief Strategist – G&A Institute

Questions:  Is Accounting as we know it now outmoded … beyond Its usefulness to investors? We share with you today the views of a global thought leader on Accounting and Corporate Reporting — Dr. Baruch Lev of Stern School of Business at New York University.

Professor Lev’s shares his views of the vital importance of intangibles to investors, with his call for far greater corporate transparency being needed … including his views on the importance of CSR and sustainability.

His latest work:  The End of Accounting – and the Path Forward for Investors and Managers — authored by Dr. Baruch Lev and Dr. Feng Gu of the University of Buffalo/ SUNY.  The professors’  important new work is the result of three years of research and collaboration, In the book they that suggests new approaches are needed to reform “old” accounting practices to provide more information of value to investors, who are mostly ignoring corporate accounting.

And as read the book, we were thinking:  what about ESG – CSR – Sustainability – and other new approaches that do focus on many intangible aspects of corporate operations?  We had a conversation with Dr. Lev and share his views on this and more with you today.

After reading the book, readers may ask:  Is this about the “The End of Accounting?” Or, “The Beginning of Really Useful Financial Information for Investors?”  My view:  It’s both!

And we discuss needed reforms in corporate reporting, for you to think about:  Are U.S. public companies prepared to publish the authors’ recommendations for a Resources and Consequences Report for investors’ benefit?  Read on to learn more…

And for sustainability / CSR professionals: This is an important new work for your consideration that focuses on the importance of intangible information for investors to help guide their decision-making.

First, some background:

Accounting as we know it has been around for 500+ years. Fra Luca Bartolomeo de Pacioli, the Italian mathematician (c 1447-1517) set out the principles of the double-entry bookkeeping system for the merchants of Old Venice in his 1494 work, Summa de Arithmetica, Geometria, Proportioni et Proportionalita, a very important textbook of the day.

This “Father of Accounting” put forth the important concepts of ledgers, journals, credits and debits (and the balancing of same); A/R, A/P, Cost Accounting and much more. His is a rich legacy in the accounting and business worlds. **

But now, Professor Baruch Lev posits in his work with colleague Professor Feng Gu, we really need to reform this five-century-old approach to how we account for the financials and think and act way beyond the traditional.

Their Recommendations:

Let’s begin with the corporate “intangibles” – some investment professionals still speak of a company’s ESG / Sustainability / Responsibility strategies, programs and actions, achievements, and the burgeoning reportage of same (data & narrative) as addressing the intangibles (and not “the tangibles,” represented by the financial data).

But many analysts and asset managers look far beyond the financials to help determine the valuation of a public issuer. For example, veteran financial analyst Stephen McClellan, CFA, formerly VP and head of research for Merrill Lynch and author of the best seller, “Full of Bull,” has told conference audiences that as much as 80% of a corporate valuation may be based on the intangibles.

Writing for investors, Professors Lev and Gu put forth their suggestions for dramatic accounting and corporate reporting reform. They “establish empirically” in their work that traditional corporate accounting is failing investors and reforms are needed.

Their recommendation: have companies publish a “Resources and Consequences Report” with five main elements:

  • Development of [Corporate] Resources;
  • Resource Stocks;
  • Preservation of Resources;
  • Deployment of Resources;
  • Value Created.

Some of the information could be financial, as in today’s disclosures. But other information could quantify data, and there could be qualitative information as well. (Sounds like we are looking at some of the sustainability reports of corporate sustainability leaders?)

The elements of the report the good professors recommend:

Development of Resources: Detailed descriptions for investors of the company’s important internal research efforts, the R&D advances, the further development of present technologies to leverage to create value, etc. After “proof of concept,” how does the R&D contribute to the value of the company?

Resource Stocks: The company’s intellectual properties, the assets that are the foundation of investor value. (Patents, trademarks, processes, etc. — all “intangibles” that are in fact very tangible to investors.)

Preservation of Resources: The safety/security of such things as a company’s digital assets, IT, IP, and so on; are there cyber attacks? Was there damage – to what extent? What does the company do about these attacks? How does the company manage and secure its acquired knowledge?

Deployment of Resources: As the company creates “value,” how are the strategic resources deployed? How does the company use its intellectual assets?

Value Created: Here the professors would like to see reported the dollar results of all of the above. Companies would describe the changes in Resource value(s), and describe the nature of value (for a company with a subscription model, what is the value of the individual subscription; what is the value of a brand, etc.)

Notes Dr. Lev: “We suggest and demonstrate a new measure: adjusted cash flows.”

Highlights of our conversation:

G&A Institute: Your new book offers very powerful arguments for fundamentally changing present-day corporate accounting and the way that investors do or do not pay attention to that accounting in their analysis and portfolio decision-making. There are a lot of vested interests in the present system; can the accounting and corporate disclosure and reporting systems be changed to reflect your recommendations?

Dr. Lev: Things change very slowly in accounting policies and practices. The systems is changing, in that public company managements are disclosing a considerable amount of information that is beyond that required for SEC filings, in the areas that we touch on in examples in our book. So there is progress. But not fast enough, I believe, to really serve investors.

G&A Institute: The SEC months ago published a Concept Release requesting public input on the present methods of corporate disclosure. We were encouraged to see more than a dozen pages in the document devoted the question of ESG metrics, sustainability information, and the like. Your thoughts on this?

Dr. Lev: We have not seen any further communication on this and there are no rules proposed. Will the new administration take any of this seriously?

Observes Dr. Lev: There are now many corporate financial statements that virtually no one understands. There is great complexity in today’s accounting. When we look at the US Environmental Protection Agency and environmental rules, we see that once rules are in place, they are constantly debated in the public arena. Unlike the EPA situation, there is presently no public interest in debating our accounting rules.

G&A Institute: Well, let me introduce here the subject of the SASB approach — the Sustainable Accounting Standards Board (SASB). Of course, the adoption of the SASB approach by a public company for adopting to their mandated reporting is voluntary at this time. What are your thoughts on this approach to this type of intangibles disclosure?

Dr. Lev: Well, the SASB recommendations are built on top of the present approach to accounting and reporting. In effect they leave the financial reporting system “as is,” with their rules built on top of a weak foundation as we outline in the book. I’ve said this at the SASB annual conference and my comments were very well received.

I did point out that the SASB approach is quite useful for investors. But the demand for voluntary disclosure by companies could create an invitation for lawsuits all over the world, if certain disclosures were made regarding a company’s environmental impacts.

G&A Institute: Well, aren’t investors seeking information such as environmental performance, as well as related risk, opportunity, more of the “E” of ESG strategies, performance, and metrics?

Dr. Lev: It depends on the setting. Our book was in process over a three-year period. My co-author and I devoted an entire year to analyzing hundreds of quarterly analyst (earnings) calls. Keep in mind that an analyst may have just one opportunity to ask the question. There were no — no — questions ever raised about ESG performance, corporate sustainability, and related topics. We reviewed, as I said, hundreds of earnings calls, with about 25-to-30 questions on each call.

G&A Institute: What kinds of questions may be directed to corporate managers on the calls about intangible items?

Dr. Lev: There were questions about the R&D efforts, the pipeline for example for pharma companies. Customer franchise was an important topic. Changes in U.S. patent law resulted in much more information being disclosed by the U.SPatent Office related to the filings. The entire argument made for patent filing, for example, and this is a subject the analysts are interested in.

G&A Institute: Are there any discussions, analyst and corporate, about ESG/sustainability?

Dr. Lev: Yes, these questions are mostly in the one-to-one conversations. A challenge is that in my opinion, the ESG metrics available are not yet at investment-grade. There is a good bit of investor interest and discussion with companies about sustainability. The factors are quite relevant to investors. But the “how-wonderful-we-are” communications by large public companies are not really relevant to investors.

G&A Institute: What kinds of information about the CSR or environmental sustainability intangibles, in your opinion, is of importance to investors?

Dr. Lev: Think about the special capabilities of the public corporation. The organization typically has special capacity to do good. Not just to donate money, which is something the shareholders could do without the company. But to share with the stakeholder, like a community organization, the special know how and other resources to make good things happen. The world really expects this now of companies. Call it Corporate Social Responsibility if you like.

The Cisco Example

Explains Dr. Lev:  Cisco is a fine example of this. The Company has a Networking Academy, and they invite people to enroll and take free educational courses to learn more about networking. There have been millions of people graduating from this academy and receiving certificates. Cisco management leverages its special capacity in doing this. And it is a good idea if you think about the impact of this far-sighted approach to generate more interest in and business with Cisco.

The Home Depot Example

Another example he offers is Home Depot. The company teams with an NGO – Kaboom — to build playgrounds for children. In terms of special capacity, HD does provide materials, but also provides company legal talent to help situate the playgrounds in the neighborhood. That is far more than throwing money at a community need.

Dr. Lev Observes:  I think one of the issues is that the terminology is not clear. CSR — what is it? Good or bad for investors? Having good ideas and special capabilities is key, I think.

We asked about Dr. Milton Friedman’s Views on CSR

G&A Institute: This brings us to one of your former colleagues, Dr. Milton Friedman of the University of Chicago, who famously wrote in a New York Times magazine article that CSR is, in effect, hokum, and not the business of the company. Shareholders well being should be the main focus, and through dividends and other means, if a shareholder wants to give the money away, they can do that…not the company.

Dr. Lev: I was a student of Dr. Friedman and later a colleague at the University of Chicago after I got a Ph.D. He was a brilliant man. In my opinion, he was the greatest economist of the 20th Century and I put him on a pedestal. He liked to introduce a subject and then generate great debate on his suggestions, which he felt people could accept or reject. That, I think, is the case with his famous commentary on CSR. See, we are still debating his views today. He was proved right so many times during his time.

G&A Institute: Let’s conclude this talk with a question: Do you see a value for investors in accepting, or better understanding, such terminology as CSR and sustainability and sustainable investing?

Dr. Lev: Yes, these are important approaches for companies and investors. Four years ago I devoted a chapter to CSR in my book, “Winning Investors Over.” My views are fully set forth in the recent article, “Evaluating Sustainable Competitive Advantage,” published in the Spring 2017 issue of Journal of Applied Corporate Finance.

Notes Dr. Lev:  About “CSR” — there are other terms used, of course. Varying titles are very confusing. It is not always clear what CSR or sustainability may mean. For example, the Toyota Prius is a good approach to auto use. Is manufacturing that car “good CSR,” or just good business? A measure of sustainability? CSR is hard to define, sometimes. Good corporate citizenship is good for business and good for society, I believe.

G&A Institute: Thank, you Dr. Lev, for sharing your thoughts on accounting and the reforms needed, in your book and in this conversation.

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Footnotes:

The book:: The End of Accounting – and the Path Forward for Investors and Managers … by Dr,Baruch Lev (Philip Bardes Professor of Accounting and Finance at the NYU Stern School of Business and Dr. Feng Gu (Associate Professor and Chair of the Department of Accounting and Law at the University of Buffalo).

Published by Wiley & Sons, NY NY. You can find it on Amazon in print and Kindle formats.

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Dr. Baruch Lev is the Philip Bardes Professor of Accounting and Finance at New York University Leonard Stern School of Business; he teaches courses in accounting, financial analysis and investor relations. He’s been with NYU for almost 20 years.

Dr. Lev is author of six books; his research areas of interest are corporate governance, earnings management; financial accounting; financial statement analysis; intangible assets and intellectual capital; capital markets; and, mergers & acquisitions.

He has taught at University of Chicago; the Hebrew University of Jerusalem; Tel Aviv University (dean of the business school); University of California-Berkeley (business and law schools). He received his Bachelor of Accounting at Hebrew University; his MBA and doctorate (Accounting/Finance) are from the University of Chicago, where he was also a professor and (student of) and then academic colleague of Nobel Laureate (Economic Sciences-1976) Dr. Milton Friedman (1912-2006).

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Dr. Milton Friedman’s article — “The Social Responsibility of Business is to Increase its Profits”; published in The New York Times Magazine, issue of September 13, 1970. The commentary for your reading is here: http://www.colorado.edu/studentgroups/libertarians/issues/friedman-soc-resp-business.html

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** Thanks to the “International Accounting Day” account of Luca Pacioli’s life, his work and his legacy. There is information available at: http://accountants-day.info/index.php/international-accounting-day-previous/77-luca-pacioli

Will We See Mandated Corporate Reporting on ESG / Sustainability Issues in the USA?

by Hank Boerner – Chairman – G&A Institute

Maybe…U.S. Companies Will Be Required…or Strongly Advised… to Disclose ESG Data & Related Business Information

Big changes in mandated US corporate disclosure and reporting on ESG factors may be just over the horizon — perhaps later this year? Or perhaps not…

Sustainable & responsible investing advocates have long called for greater disclosure on environmental and social issues that affect corporate financial performance (near and long-term). Their sustained campaigning may soon result in dramatic changes in the information investors and stakeholders will have available from mandated corporate filings.

We are in countdown mode — in mid-April the Securities & Exchange Commission (SEC), the agency that regulates many parts of the capital market operations and especially corporate disclosure and reporting for investors issued a Concept Release with a call for public comments.

Among the issues In focus are potential adjustments, expansions and updating of mandated corporate financial reporting. One of these involves corporate ESG disclosure. The issue of “materiality” is weaved throughout the release.

Among the many considerations put forth by SEC: expanding corporate disclosure requirements for corporate financial and business information to include ESG factors, and to further define “materiality.” Especially the materiality of ESG factors.

The comment period is open for you to weigh in with your opinion on corporate ESG disclosure and reporting rules — or at least strong SEC guidance on the matter.

SEC has been conducting a “Disclosure Effectiveness Initiative,” which includes looking at corporate disclosure and reporting requirements, as well as the forms of presentation and methods of delivery of corporate information made available to investors. (Such as corporate web site content, which most feel needs to be updated as to SEC guidance.)

The umbrella regulatory framework — “Regulation S-K” — has been the dominant approach for corporate reporting since 1977 has been the principal repository (in SEC lingo) for filing corporate financial and business information (such as the familiar 10-K, 10-Q, 8-K, etc.).

Investors Want More Corporate ESG Information

For a number of years now, investment community players have urged SEC to look at mandating or offering strong guidance to public company managements to expand disclosure and reporting to substantially address what some opponents conveniently call “non-financial,” or “intangible” information. An expanding base of investors feel just the opposite — ESG information is quite tangible and has definite financial implications and results for the investor. The key question is but how to do this?

Reforming and Updating Reg S-K

In December 2013 when the JOBS Act (“Jumpstart Our Business Startups”) was passed by Congress, SEC was charged with issuing a report [to Congress] on the state of corporate disclosure rules. The goal of the initiative is to improve corporate disclosure and shareholders’ access to that information.

The Spring 2016 Concept Release is part of that effort. The SEC wants to “comprehensively review” and “facilitate” timely, material disclosure by registrants and improve distribution of that information to investors. Initially, the focus is on Reg S-K requirements. Future efforts will focus on disclosure related to disclosure of compensation and governance information in proxy statements.

Asset managers utilizing ESG analytics and portfolio management tools cheered the SEC move. In the very long Concept Release – Business and Financial Disclosure Required by Regulation S-K, at 341 pages — there is an important section devoted to “public policy and sustainability” topics. (Pages 204-215).

ESG / Sustainability in Focus For Review and Action

In the Concept Release  SEC states: In seeking public input on sustainability and public policy disclosures (such as related to climate change) we recognize that some registrants (public companies) have not considered this information material.

Some observers continue to share this view.

The Concept Release poses these questions as part of the consideration of balancing those views with those of proponents of greater disclosure including ESG information:

• Are there specific public policy issues important to informed voting and investment decisions?

• If the SEC adopted rules for sustainability and public policy disclosure, how could the rules result in meaningful disclosures (for investors)?

• Would line items about sustainability or public policy issues cause registrations to disclose information that is not material to investors?

• There is already sustainability and ESG information available outside of Commission (S-K) filings — why do some companies publish sustainability, citizenship, CSR reports…and is the information sufficient to address investor needs? What are the advantages and disadvantages of these types of reports (such as being available on corporate web sites)?

• What challenges would corporate reporters face if ESG / sustaianbility / public policy reporting were mandated — what would the additional costs be? (Federal rule making agencies must balance cost-benefit.)

• Third party organizations — such as GRI and SASB for U.S. company reporting — offer frameworks for this type of reporting. If ESG reporting is mandated, should existing standards or frameworks be considered? Which standards?

The Commission has received numerous comments about the inadequacy of current disclosure regarding climate change matters. And so the Concept Release asks: Are existing disclosure requirements adequate to elicit the information that would permit investors to evaluate material climate change risk? Why — or why not? What additional disclosure requirements– or SEC guidance — would be appropriate?

Influential Voices Added to the Debate

The subject of expanded disclosure of corporate ESG, sustainability, responsibility, citizenship, and related information has a number of voices weighing in. Among those organizations contributing information and commentary to the SEC are these: GRI; SASB; Ceres; IEHN; ICCR; PRI; CFA Institute; PWC; E&Y; ISS; IIRC; BlackRock Institute; Bloomberg; World Federation of Exchanges; US SIF.

The overwhelming view on record now with SEC is that investor consideration of ESG matters is important and that change is needed in the existing corporate reporting and disclosure requirements. You can add your voice to the debate.

For Your Action:

I urge your reading of the Concept Release, particularly the pages 204 through 215, to get a better understanding of what is being considered, especially as proposed by proponents; and, I encourage you to weigh in during the open public comment period with your views.

You can help to ensure the SEC commissioners, staff and related stakeholders understand the issues involved in expanding corporate disclosure on ESG matters and how to change the rules — or offer strong SEC guidance. Let the SEC know that ESG information is needed to help investors better understand the risks and opportunities inherent in the ESG profiles of companies they do or might invest in.

SEC rules or strong guidance on ESG disclosure would be a huge step forward in advancing sustainability and ESG consideration by mainstream capital market players.

Information sources:

The SEC release was on 13 April 2016; this means the comment period is open for 90 days, to mid-July.

Helpful Background For You

Back in 1975 as the public focus on environmental matters continued to increase (all kinds of federal “E” laws were being passed, such as the Clean Air Act and Clean Water Act), stakeholders asked SEC to address the disclosure aspects of corporate environmental matters.

The initial proposal was deemed to have exceeded the commission’s statutory authority.

In 1974 the ERISA legislation had been passed by Congress, and pension funds, foundations and other fiduciaries were dramatically changing the makeup of the investor community, dwarfing the influence of one once-dominant individual investor. After ERISA and the easing of “prudent man” guidelines for fiduciaries, institutional investors rapidly expanded their asset holdings to include many more corporate equities.

And the institutions were increasingly focused on the “E,” “S” and :”G” aspects of corporate operations — and the real or potential influence of ESG performance on the financials. Over time, asset owners began to view the company’s ESG factors as a proxy for (effective or not) management.

While the 1975 draft requirements for companies to expand “E” and “S” information was eventually shelved by SEC, over the years there was a steady series of advances in accounting rules that did address especially “E” and some “S” matters.

FAS 5 issued by FASB in March 1975 addressed the “Accounting for Contingency” costs of corporate environmental liability FASB Interpretation FIN 14 regarding FAS 5 a year later (September 1976) addressed interpretations of “reasonable estimations of losses.” SEC Staff Bulletins helped to move the needle in the direction of what sustainable & responsible investors were demanding. Passage of Sarbanes-Oxley statutes in July 2002 with emphasis on greater transparency moved the needle some more.

But there was always a lag in the regulatory structure that enables SEC to keep up with the changes in investment expectations that public companies would be more forthcoming with ESG data and other information. And there was of course organized corporate opposition.

(SEC must derive its authority from landmark 1933 and 1934 legislation, expansions and updates in 1940, 2002, 2010 legislation, and so on. Rules must reflect what is intended in the statutes passed by Congress and signed into law by the President. And opponents of proposals can leverage what is/is not in the laws to push back on SEC proposals.)

There is an informative CFO magazine article on the subject of corporate environmental disclosure, published September 9, 2004, after the Enron collapse, two years after Sarbanes-Oxley became the law of the land, and 15+ years after the SEC focused on environmental disclosure enhancements. Author Marie Leone set out to answer the question, “are companies being forthright about their environmental liabilities?” Check out “The Greening of GAAP” at: http://ww2.cfo.com/accounting-tax/2004/09/the-greening-of-gaap/

And we add this important aspect to corporate ESG disclosure: Beginning in 1990 and in the years that followed, the G1 through G4 frameworks provided to corporate reporters by the Global Reporting Initiative (GRI) helped to address the investor-side demand for more ESG information and the corporate side challenge of providing material information related to their ESG strategies, programs, actions and achievements.

The G&A Institute team sees the significant progress made by public companies in the volume of data and narratives related to corporate ESG performance and achievements in the 1,500 and more reports that we analyze each year as the exclusive data partner for The GRI in the United States, United Kingdom, and The Republic of Ireland.

We have come a very long way since the 1970s and the SEC Concept Release provides a very comprehensive foundation for dialogue and action — soon!

Please remember to take action and leave your comments here:
http://www.sec.gov/rules/concept.shtml

Benefit Corporations and the Public Markets — Will We Ever See a Public Benefit Corporation?

Lois Yurow-Nov 14-016eQuestion:  Benefit Corporations and the Public Markets — Will We Ever See a Public Benefit Corporation?

by Guest Commentator Lois Yurow

The United States is home to over 1,100 privately-held benefit corporations—for-profit entities organized under state statutes that require them to pursue a general public benefit in the ordinary course of business.  Many commentators have discussed whether directors of socially-oriented companies need legislation to protect them from liability for breach of fiduciary duty when they strive for goals other than financial return.  Others have argued that benefit corporation legislation is counterproductive because it wrongly implies that traditional corporations are required to make shareholder value their exclusive priority. 

This essay will not revisit those issues.  Instead, I want to consider whether it would be viable for a public company to become a benefit corporation, or for a benefit corporation to go public.  I will describe benefit corporations and some distinct obligations of public companies, and then explain why benefit corporations are not suited to the public markets.

Benefit corporations, B corporations, and public companies

Corporate law in 26 states and the District of Columbia permits for-profit entities to become benefit corporations.[1]  The various state statutes differ, but all benefit corporations have three distinct features: charter documents must state that the corporation’s purpose is to create a material, positive impact on society and the environment; benefit corporation directors must consider the interests of stakeholders other than shareholders, such as employees and the surrounding community; and benefit corporations must report periodically on their social and environmental performance. 

The first benefit corporation statute was enacted (by Maryland) roughly five years ago, placing benefit corporations among the rare subjects that garner bipartisan support and inspire legislative speed.  Currently, there are 1,140 known benefit corporations in the United States.  The most familiar are Method Products (which makes cleaning supplies) and Patagonia (which specializes in outdoor apparel).

Benefit corporations are easily confused with B corps, but they are different.  A B corp is an entity—not necessarily a corporation—that is certified by B Lab, a nonprofit organization committed to “using the power of business to solve social and environmental problems.”  Unlike programs to certify a particular product (say, Fair Trade coffee) or facility (an LEED building), the B Lab certification is comprehensive.  The idea is to identify good companies instead of just good products or good marketing.  As of this writing, there are 1161 B corps in 37 countries.  Some are benefit corporations, but most are not.  The most recognizable B corp is Ben & Jerry’s.

Public companies offer their shares to the general public, typically on a stock exchange.  To become public, a company must file with the Securities and Exchange Commission (the “SEC”) a registration statement that contains audited financial statements and describes the business and the risks of the investment.  Once public, the company is subject to ongoing reporting and auditing requirements.  According to B Lab (a driving force behind benefit corporation legislation), no existing benefit corporation is publicly traded.[2]

Existing corporations cannot convert into benefit corporations without the approval of a supermajority of their shareholders.  It would be difficult for a public company to muster that support.  But could a benefit corporation go public?  That would be a bad idea, for two reasons: becoming and remaining a public company is too expensive, and broad ownership might jeopardize the company’s mission. 

Going public is too expensive

According to a 2011 study prepared by the IPO Task Force for the U.S. Treasury Department, it costs approximately US$2.5 million for a company to achieve regulatory compliance for an initial public offering, and another $1.5 million per year for ongoing compliance. These costs include underwriting commissions; filing fees; and fees for lawyers, accountants, and transfer agents.  Even typical for-profit companies need to be large and successful to absorb those costs.  For a benefit corporation that already may need to sacrifice potential earnings, steep compliance costs would further diminish the company’s resources for engaging in business and pursuing a public benefit.

Moreover, the SEC’s disclosure regime focuses on financial and economic analysis; it does not elicit the type of social benefit assessment that benefit corporations must provide under state law.  Indeed, many investors have complained to the SEC about inadequate reporting of environmental, social, and governance (ESG) information.  Thus, a public benefit corporation that produced the periodic reports required by federal law would still need to prepare an annual benefit report to satisfy state law. 

Under the Model Benefit Corporation Legislation, which is the starting point for most state laws, the benefit report must describe “[t]he ways in which the benefit corporation pursued general public benefit during the year and the extent to which general public benefit was created,” and assess “the overall social and environmental performance of the benefit corporation against a third-party standard.”  This is not an inconsequential or inexpensive undertaking. 

Benefit corporations are more likely to succeed with a small number of investors

Benefit corporations commit to pursue (in some states, to “create”) a public benefit, which serves as a signal to socially responsible investors.  As corporate law professor Lynn Stout says, “‘it’s like hanging a sign around your neck: Nice people invest here.’”[3]  One commentator likens benefit corporations to multiparty contracts because they “average the collective desires” of unrelated investors with a variety of social concerns.[4]  Those who invest in a benefit corporation—or opt in to the contract—are  “a self-selected, ideologically similar group” that is likely to remain committed to the company’s mission, even in circumstances that might prompt profit-oriented investors to insist that management defer social endeavors to pursue better returns.

This contractual dynamic could shift if a benefit corporation were to go public.  Activist investors often buy stock with complete understanding of a company and then agitate for change anyway.  Witness the public battles waged by investors urging EBay, EMC, and JDS Uniphase (among others) to spin off assets. 

If a benefit corporation’s business model has substantial earnings potential absent the “public benefit” mission, there is nothing to stop frustrated investors from campaigning to amend the company’s charter.  Even if activists cannot attain the supermajority vote that benefit corporation statutes require, defending the company’s mission would be a significant distraction and expense for management.

Conclusion: 

Benefit corporations appeal to the subset of investors that are willing to sacrifice some earnings to support more responsible business practices.  These companies are unlikely to generate enough new capital in the public market to justify the expense of being there.  In addition, offering stock to the general public, without any opportunity to assess the purchasers’ commitment, can jeopardize a benefit corporation’s mission.  This class of companies should stay in the private market.

Footnotes:


[1] This tally includes Arizona, where the statute is not effective until December 31, 2014, and Minnesota and New Hampshire, where the statutes are not effective until January 1, 2015.  Legislation is pending in twelve other states and Puerto Rico.

[2] Plum Organics, a benefit corporation, is wholly-owned by Campbell Soup Company, a public company.

[3] Quoted in Gunther, M. (2013, August 12). B corps: Sustainability will be shaped by the market, not corporate law. The Guardian. Retrieved from http://www.theguardian.com/sustainable-business/b-corps-markets-corporate-law.

[4] Hasler, J. E. (2014, October). Contracting for good: How benefit corporations empower investors and redefine shareholder value. Virginia Law Review, 100(6), 1279-1322, 1305.

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Guest Commentator Lois Yurow is founder and president of Investor Communications Services, LLC, where she specializes in converting complex legal, business, and financial documents into plain English.  Lois was Managing Editor of Wall Street Lawyer, a monthly newsletter focused on securities law, for seven years, and Managing Editor of RealCorporateLawyer.com, a website serving corporate and securities lawyers, for five.  Mutual Fund Regulation and Compliance Handbook, a book Lois co-authored and updates annually, is published by Thomson West.  Lois writes and speaks frequently about plain English, disclosure, and other securities law matters.  Before forming Investor Communications Services, Lois practiced corporate and securities law, first in Chicago and then in New Jersey.  Email: lois@securitieseditor.com

 

 

The Role of Individual Investors in Prompting Governance Reform via the Proxy Process

guest commentary by Tim Smith – Walden Asset Management

We have all read a great deal about the concern that companies, the [US] Chamber of Commerce and SEC Commissioner Gallagher have about the “highjacking” of the proxy process.

Particular anger is aimed at John Chevedden, Bill Steiner  and James McRitchie who file multiple resolutions on governance reforms — like majority vote, annual election of directors, changing different classes of shares with unequal voting rights, right for shareholders to call a special meeting and separate Chair and CEO, among others.

Mr. Chevedden is criticized for some of the language in his resolution texts as well as his seeming unwillingness to change false and misleading statements in the whereas clauses . In fact, 4 companies sued him this year to block resolutions he submitted either for himself as a shareholder or for colleagues like James McRitchie.

But it seems much of the frustration is not aimed at him but at the strong positive votes for such reforms  supporting many of these proposals . On many governance issues he coordinates and files, votes are in the 30 to 40 % range AND as you will see below many get well over 50%. Few are low level vote getters.

So while questions can be raised about the style of Mr. Chevedden’s engagements, few can argue that they don’t touch a nerve and get a positive investor response .

That leaves one questioning why SEC Commissioner Gallagher sees this as an abuse and believes there should be an increase in the value of shares held for a proponent to US$200,000 or “even better $2 million.”  Of course, such a change would virtually wipe out the role of small individual investors in the proxy process.

Another way to view it is that these are valuable governance reforms being tested by individual shareholders who could certainly brush up on the facts in their whereas clauses and open up engagement with companies — but nevertheless add real value to an ongoing debate about best governance practices and actually stimulate numerous reforms by companies .

Why is a resolution filed by a major pension fund or investment firm on the same topic any more meritorious than one by an individual shareholder?

The votes seem to indicate that proxies are voted on the issue — not the proponent.

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–Timothy Smith, Senior Vice President and Director of Environmental Social and Governance Shareowner Engagement Walden Asset Management .

Boston, MA 02108 – Tel: 617-726-7155

tsmith@bostontrust.com

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FYI – Samples of Votes With Over 50% – Companies Receiving Resolutions from John Chevedden:

 

Costco Wholesale Corporation (COST)
Simple Majority Vote
James McRitchie
65%

Brocade Communications Systems, Inc. (BRCD)
Special Meeting Kenneth Steiner 60%

Allergan, Inc. (AGN)
Independent Board Chairman
John Chevedden
50%+

BorgWarner Inc. (BWA)
Simple Majority Vote
John Chevedden
79%

Brink’s Company (BCO)
Annual Election of Each Director
William Steiner
78%

Bristol-Myers Squibb Company (BMY)
Simple Majority Vote
Kenneth Steiner
85%

Chipotle Mexican Grill, Inc. (CMG)
Simple Majority Vote
James McRitchie
75%

Duke Energy Corporation (DUK)
Special Meeting
John Chevedden
60%

iRobot Corporation (IRBT)
Simple Majority Vote
James McRitchie
82%

PPL Corporation (PPL)
Special Meeting
William Steiner
59%

NextEra Energy, Inc. (NEE)
Simple Majority Vote
Myra K. Young
73%

Alexion Pharmaceuticals, Inc. (ALXN)
Pill
John Chevedden
91%

Ferro Corporation (FOE)
Simple Majority Vote
Kenneth Steiner
99%

Neustar Inc (NSR)
A
nnual Election of Each Director
John Chevedden
86%

Staples Inc. (SPLS)
Independent Board Chairman
John Chevedden
50%+

The CEO and the Average Worker – What’s the Ratio? Of Top Pay to the Rank & File – Disclosures to Come

by Hank Boerner – Chairman, G&A Institute

The Dodd-Frank investor protection and financial industry reform legislation — officially, the Dodd Frank Wall Street Reform and Consumer Protection Act — became the law of the land in July 2010 when President Barack Obama signed the measure.   It’s usually estimated that roughly half of the measures included are still in process to become the operating rules-of-the road for U.S. financial service sector firms.  Commercial banks, credit card companies, credit information bureaus, consumer lenders, investment banks, bank holding companies, investment bankers, regulatory authorities, and others will be subject to the rules backed up by the statutory authority embodied in Dodd Frank.

The recent crisis in the American financial services system spread quickly to affect millions of U.S. citizens and over time, millions more citizens of other lands.  We are still working our way out of the Great Recession that resulted from events in 2007-2008-2009.  (The old saw is that a recession is when your neighbor is laid off, a depression is when you get the axe.)  For many Americans, this is a depression — for folks who cannot find a job, pay down mortgages, cannot afford tuition, are working part-time ’cause that’s all there is, the unemployment payments ran out, and more.

Dodd Frank is actually 16 “titles” or sections (Sarbanes Oxley earlier was 11 titles), requiring several hundred rules to be adopted, as well as studies conducted and periodic progress reports issued.  This was all to “improve accountability and transparency,” among many noble or at least well-meaning intentions.

Dodd-Frank addressed the issue of CEO compensation, with such measures as having shareholders vote to approve exec comp and golden parachute compensation (Section 951).  Also, there was a mandate for having a shareholder “advisory” vote to determine who often the company would conduct a shareholder vote on compensation. That was the easy part it turned out.  The hard part?  Section 953 — requiring “…disclosure about certain compensation matters, including pay-for-performance and the ratio between the CEO’s total compensation and the media total compensation for all other company employees…”  Although the other parts of the Section were not popular, this one was the whopper.  Despite intense lobbying efforts to stop rule-making, we saw the news last week that SEC has moved along…953 rule making is in the final stages.

Consider that in this still recovering economy we have been transitioning to a have/have not situation, with some of the haves are doing very nicely, thank you.  Count among the blessed folk certain of the higher paid CEOs of large public companies. The gap between worker and chieftain pay has been widening for years, of course, but the public notice about this has been episodic.  I remember when health care “reform” was being discussed in the Clinton era reading that it was not fair that CEOs of HMOs were being paid 97 times that of the skilled intensive care unit nurses.    

CNN Money in April 2012 reported that CEO pay was now 380 times the average worker’s, according to analysis by the AFL-CIO, as the largest company CEOs earned an average of  US$12.9 million vs. the average worker pay of $34,053, according to the Bureau of Labor Statistics.  And that was 14% higher than in 2010 when the CEO average was $11.4 million. (300 large companies were analyzed.)  Back in 1980, said the union group, the pay was 42 times the average worker…by 2000 the gap was at 525X.  (The union has had a web site up with this information for the past 15 years and has kept the conversation about CEO pay going with media, public officials, union members, and others.)

So now to the rulemaking:  On September 18th the SEC commissioners voted along party lines – 3-2 — to propose a new rule requiring public companies to disclose the ratio of the compensation of its CEO to the median comp of employees.  No specific methodology is prescribed…each company “would have the flexibility to determine the median annual total compensation of its employees in a way that best suits its particular circumstances…”

The compensation advisory company Meridian Compensation Partners LLC is circulating information about the proposed rule to clients and stakeholders.  The partners point out that important issues for the companies to address include (1) what employees are to be included (all means full, p/t, seasonal, temps); (2) determining the median; (3) determining the CEO pay ratio; (4) calculating the Median Employee Total Compensation.  The result can be expressed as “1 to 200X” or “200X that of.”  (more information at:  www. meridiancp.com)

We have 60 days to go for public comment — SEC has prepared 160+ pages of documentation to explain the disclosures required.   That’s a small amount of paper (or digital file) compared to the headlines and reams of print content that we will be seeing in the months ahead if the rule is adopted and as public companies begin to disclose the “1-to-200 times” difference in pay levels.  All of this will add to the earnest debate about the income and wealth gap and the continued dwindling of the American Middle Class.  We’ve been tracking this issue since the 1980s and we see an intensifying public conversation coming on CEO pay and the growing gap with the worker media.  This will likely heat up at specific companies come the 2014 proxy season.

This is a hot issue about to heat up more — Stay Tuned!